Foundations of Finance
MCREY BANDERLIPE II, MSc (CPA)
Objectives
Understand finance the Identify the goal of the firm.
fields of finance. Explain the 10 principles that
Know the role of financial form the foundations of
managers finance.
Compare the various legal
forms of business
Explain what has led to the
organization and explain era of the multinational
why the corporate form of corporation.
business is the most logical
choice for a firm that is
large or growing.
What is Finance
Finance is a discipline concerned with
identifying, evaluating, and managing sources
and uses of cash in order to increase the value
of the business enterprise to its present
owners.
Tasks involved in finance:
Identify sources and uses of cash (Opportunities)
Evaluate cash flows (Cost-benefit ranking)
Manage cash flows (Realizing of benefits)
Finance and FM – Why study?
Finance is taking a big role in every organization.
Other business fields also rely on them.
Three fields:
Money and Capital Markets (MCM) – lenders/investors and
borrowers exchange money for their benefit.
Investments (I) – decision process that stems from a transaction
between investor and borrower.
Financial Management (FM) – specific to the business itself as it
is concerned to efficient use of money in conducting operations.
FM delves on how to select the best assets & how to
mix equity and debt capital to support the assets in
meeting financial requirements.
Responsibilities of Financial Managers
Forecasting and planning – constant preparation of
forecasts and make appropriate actions to prepare for the
predicted events.
Investment and financing decisions – acquire assets that
support business operations given the co.’s financial
resources and plans.
Coordination and control – take corrective action when
performance is less than expected.
Dealing with capital markets – know the mutually
beneficial dynamics of the interaction among investors
and borrowers.
Applying Financial Management to the
Legal Forms of Business Organization
Sole Proprietorship
Partnership
Corporation
Sole Proprietorship
Business owned by an individual
Owner maintains title to assets and profits
Unlimited liability
Termination occurs on owner’s death or by
owner’s choice
Partnerships
Two or more owners
General Partnership
Each partner is fully responsible for
liabilities
Limited Partnerships
Partnerships
Limited Partnership and Limited Liability
Company
Allows one or more partners limited liability based
on amount of capital invested
Must have one general partner with unlimited
liability
Names of limited partners may not appear in name
of firm
Limited partners may not participate in
management decisions.
Corporation
Legally functions separate and apart from its
owners
Can sue, be sued, purchase, sell, and own property
Owners who dictate direction and policies
Elect a board of directors
Investors liability is restricted to amount of
investment in company
Life continues with transfer of ownership
Taxed separately
Comparison of Organizational Forms
Large growing firms choose the corporate
form
Ease in raising capital
Limited liability
Transfer of ownership is simple
Comparison of Organizational Forms
Sole Proprietorship and General Partnership
Unlimited liabilities
Not as easy to raise capital
Limited Partnership
Limited liability for partners
Practical number of partners restricted
Restricted marketability of interest in partnership
The Role of the Financial Manager in a
Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION
The Goal of the Firm (and The Ultimate Goal
of Finance)
The goal of the firm is to maximize shareholder
wealth
or
Maximize the price of an existing common stock
Profit Maximization
Stresses the efficient use of capital resources
Not specific to time frame for profits to be measured
Goals are not precise, allow for misinterpretation
Ignores uncertainty and timing
Benefits of Maximizing Shareholder
Wealth
Good decisions are those that create wealth for
the shareholder
Societal benefits as businesses compete to create
wealth
Includes effects of all financial decisions
Ten Principles that Form the Foundations
of the Study of Finance (Keown, et al.,
2005)
“…although it is not necessary to understand finance
in order to understand these principles, it is
necessary to understand these principles in order
to understand finance” (p. 13).
Principle 1: The Risk-Return Trade-off
We won’t take on additional risk unless we expect
to be compensated with additional return.
Investment alternatives have different amounts of
risk and expected returns.
The more risk an investment has, the higher its
expected return will be.
Principle 2: The Time Value of Money
A peso received today is worth more than a peso
received in the future.
Because we can earn interest on money received
today, it is better to receive money earlier rather
than later.
Principle 3: Cash - Not Profits - is King
Cash Flow, not accounting profit, is used as our
measurement tool.
Cash flows, not profits, are actually received by
the firm and can be reinvested.
Principle 4: Incremental Cash Flows
It is only what changes that counts
The incremental cash flow is the difference
between the projected cash flows if the project is
selected, versus what they will be, if the project is
not selected.
Principle 5: The Curse of Competitive
Markets
It is hard to find exceptionally profitable projects
If an industry is generating large profits, new
entrants are usually attracted. The additional
competition and added capacity can result in
profits being driven down to the required rate of
return.
Product Differentiation, Service and Quality can
insulate products from competition
Principle 6: Efficient Capital Markets
The markets are quick and the prices are right.
The values of all assets and securities at any
instant in time fully reflect all available
information.
Principle 7: Agency Problem
Managers won’t work for the owners unless it is in
their best interest (Jensen and Meckling, 1976)
The separation of management and the ownership
of the firm creates an agency problem.
Managers may make decisions that are not in line with
the goal of maximization of shareholder wealth.
Principle 8: Taxes Bias Business Decisions
The cash flows we consider are the after-tax
incremental cash flows to the firm as a whole.
Principle 9: All Risk is Not Equal
Some risk can be diversified away, and some
cannot.
The process of diversification can reduce risk, and
as a result, measuring a project’s or an asset’s risk
is very difficult.
Principle 10: Ethical Behavior is Doing the
Right Thing, and Ethical Dilemmas are
Everywhere in Finance
Each person has his or her own set of values, which
forms the basis for personal judgments about what
is the right thing.
“Unethical behavior eliminates trust and without
trust, business cannot interact.”
“The loss of public confidence in ethical standards
is most damaging to the business.”
Finance and the Multinational Firm
Corporations are looking to international
expansion
Collapse of communism
Acceptance of free market system developing
in the Third World countries
PCs and the Internet
Freer access to international markets
Summing up…
Understanding Finance and Financial Management is important
for every organization.
The responsibilities under finance and financial management is
essential to ensure stability, growth, and profitability of
organizations.
While all businesses make financial decisions, financial
management is much more applicable in corporate forms of
organization.
The ultimate goal of the firm (which is the ultimate goal of
finance) is to maximize shareholder wealth.
Given the principles, finance professionals must act with a
strong sense of ethical conduct so as to enhance the
maximization of shareholder wealth.
Foundations of Finance
MCREY BANDERLIPE II, MSc (CPA)
